When the governing council of the European Central Bank meets in Frankfurt on Thursday, it is widely expected to announce a loosening in policy – most likely a cut in both the refinancing and deposit rates.Two weeks later, the US Federal Reserve will probably respond to strengthening economic data by moving in the opposite direction, tapering the pace of quantitative easing for the fifth consecutive meeting. This is another sign of how monetary policy is diverging in the twolargest economies, a trend that is set to shape funding markets for years to come.

In the US, output is set to rebound in the second quarter after having been disrupted by dismal weather in the first. And while price rises have been subdued so far, employment surveys suggest an emerging skills shortage and thus the potential for wage cost growth that could help lift inflation close to the Fed’s 2 per cent target. By any measure the labour market is tighter in America than in Europe, where the recovery remains weak and uneven despite buoyant financial markets. The gap between actual and potential output will barely shrink in the eurozone this year, and unemployment will remain close to a record high.

Before long, these divergent fortunes are bound to lead to large differences in policy.In the US, interest rates could begin to rise in 2015. In Europe, they are likely to stay low for much longer.

One might expect that movements in financial markets would reflect these expectations.However, so far, by and large, they have not. The dollar has been ailing for months, defying analysts’ expectations that the currency would strengthen in anticipation of higher US interest rates. What is going on?The answer is that market expectations seem to count less than current conditions, which still support the euro.First, the high yields on government debt in countries such as Italy and Spain have made them an attractive investment for believers in the ECB’s pledge to do “whatever it takes” to save the euro. Second, America’s shrinking pension deficits may have stoked appetite among pension-fund managers to lock in profits and match liabilities, helping suppress long-term bond yields. And then there are the central banks. The Eurosystem’s balance sheet has been shrinking for more than a year, as banks that borrowed from the central bank under the longer-term refinancing operation (LTRO) have repaid their debts early. Meanwhile, the Fed’s balance sheet is still growing, albeit at a reduced rate. However, these factors are temporary.LTRO repayments are coming to an end, US quantitative easing will be completed by the end of the year, five-yeargovernment bond yields in Spain are already similar to those in America and long-dated US government bond yields are pricing in unrealistically low expectations of future economic growth. Diverging monetary policy will soon begin to have more impact.To my mind, investors should prepare for more volatility this year. The degree of easing of US monetary policy has been exceptional. The tightening, when it begins, will also be unprecedented. The tightening has not yet begun – the Fed’s balance sheet is still expanding. I see significant potential for volatility and setbacks on financial markets over the next few quarters. In particular, the story is not over for emerging-market countries that rely on cheap dollar funding.The recovery of their stock markets and currencies in the past months does not reflect improved economic fundamentals, but a better mood among investors. These countries are still vulnerable. When US interest rates begin to rise, these borrowers may be able to turn to euro-denominated debt as an alternative source of cheap financing. However, this at best delays adjustment; improving fundamentals remains urgent.The Fed’s balance sheet, which was about half the size of the Eurosystem’s going into the crisis, has now overtaken its European counterpart as a proportion of output. Emerging markets will not be the only ones to suffer whenthis trend goes into reverse. A tightening in US monetary policy always causes fallout. This time will be no different. In fact, it may be worse, since the tightening starts from extremely expansionary territory.

The writer is chairman of UBS and a former president of Germany’s Bundesbank

I am writing this introductory note from London during a layover on my way to Rome, and I’ll append a personal ending tonight after I finally make my way back from dinner to the hotel.One of the few consensus ideas that I took away from the Strategic Investment Conference is that China has the potential to become a real problem. It seemed to me that almost everyone who addressed the topic was either seriously alarmed at the extent of China’s troubles or merely very worried. Perhaps it was the particular group of speakers we had, but no one was sanguine. If you recall, a few weeks back I introduced my young colleague and protégé Worth Wray to you; and his inaugural Thoughts from the Frontline focused on China, a topic on which he is well-versed, having lived and studied there. Our conversationsoften center on China and emerging markets (and we tend to talk and write to each other a lot).While I’m on the road, Worth is once again visiting China in this week’s letter, summing up our research and contributing his own unique style and passion. I think regular TFTF readers are going to enjoy Worth’s occasional missives and will want to see more of them over time.Now, let’s turn it over to my able young Cajun friend.Editors’ note:With John up to his eyeballs in prosecco and peaches there on the patio in Trequanda this morning and with Worth just getting the sleep out of his eyes in Houston, we are hereby making an executive decision to split this 22-page beast masterpiece right up its middle and bring you the second half next week … which will give both these guys some well-earned rest! – Charley & Lisa Sweet

Looking at the Middle Kingdom with Fresh Eyes

By Worth Wray (Houston, TX)

In my Thoughts from the Frontline debut this past March (“China’s Minsky Moment?”), I highlighted the massive bubble in Chinese private-sector debt and explored the near-term prospects for either(1) a reform-induced slowdown or (2) a crisis-induced recession. Unfortunately, it was not an easy or straightforward analysis, considering the glaring inconsistencies between “official” state-compiled data and more concrete measures of real economic activity.

More Questions Than Answers

Although John and I spend hours every week searching for the truth in a murky stream of official and unofficial reports, we always reach the same conclusion about the People’s Republic: There is really no way to know what is happening in China today, much less what will happen tomorrow, based on widely available data.The primary data is flawed at best and manipulated at worst. Sometimes the most revealing insights lie in the disagreement between the official and unofficial reports… suggesting that official data is useful only to the extent that we think about it as state-sanctioned propaganda. In other words, it tells us what Chinese policymakers want the world to believe.This shortfall in credible and actionable data from one of the global economy’s largest and most interconnected members leaves us with more questions than answers – especially in the presence of a massive Chinese credit bubble, with clear signs of overinvestment and unsustainably high debt-service ratios.These are troubling signs for all investors, in every asset class, everywhere in the world today… and everyone should be paying close attention.(I should note that John has access to a massive amount of research from a very wide variety of both traditional and nontraditional sources… and I say that after having extraordinary access myself as the portfolio strategist for an $18B Texas money manager. I am seeing and reading things every day that I could only imagine before, and the information flow is addictive. John’s sources give us a big, if sometimes overwhelming, head start on thinking through all the implications for investing around the constant collisions of macroeconomic forces. While we legally and ethically cannot share some of the best research we see, we can share a lot of the core ideas and do our best to give you a head start, too. That’s whatthis letter is about.)

Read the Tea Leaves Carefully & Expect Miscues

Most China economists – who do the best they can to read the economic tea leaves by focusing on a handful of economic indicators ranging from gross domestic product (GDP), purchasing managers’ indices (PMI), consumer/producer inflation (CPI/PPI), total social finance, and industrial production – end upexpressing a rather bipolar view on Chinese economic activity, with wild swings in their outlooks from quarter to quarter. On this front, I was particularly impressed by an explosive letterfrom our friends at Political Alpha, which remains one of the elite political intelligence/analysis firms on the Street.While China watchers tend to trade reactively aroundofficial and unofficial manufacturing PMI releases as monthly proxies for the broader economy, very few investors realize that “not only is manufacturing no longer the bellwether of the [Chinese] economy, more often than not it now performs counter-cyclically.”Although China is the world’s largest producer of value-added manufactured goods, it has not been an export-led economy for a very long time.As I detailed in last month’s letter, China’s growth has largely relied on extraordinarily high levels of fixed investment, supported by even higher levels of domestic savings and an unsustainable rise in private-sector credit.

Even so, industry experts often fall into the trap of extrapolating flash manufacturing readings into forecasts for the broader economy.Our friends at Political Alpha describe one such situation where HSBC’s China team (which puts out the unofficial monthly PMI each month in partnership with MarkIt) “was forced to backpedal from its September 23rd announcement that the flash PMI data was ‘further evidence [of] China’s ongoing growth rebound’ to a much more somber conclusion just seven dayslater: ‘There are still a lot of structural headwinds ahead. This is as good as it gets for the time being. [D]on’t expect too sharp an acceleration from here.’”Feel free to compare the clips yourself:• HSBC release on 9/23: http://www.cnbc.com/id/101053388• HSBC release on 9/29: http://www.cnbc.com/id/101071631On a side note, I don’t mean to disparage the China research team at HSBC or question their competency by reprinting the comments above.I’m sure they get up each morning (just like I do) with a genuine intent to understand changing economic conditions as best they can and to help their clients protect and grow their savings. If anything, this example is a broader indictment of investors’ widespread reliance on a handful of flawed or misunderstood data points in the absence of credible Chinese economic data.I don’t mean to be cute or coy on this issue. The lack of transparency of the Chinese economy is not just a problem for individual and institutional investors who make the choice every day to put their money at risk; it also carries enormous policy implications for central bankers and elected politicians in a highly unstable global system where total debt-to-GDP has risen across the world’s major economies by nearly35% since 2008… and continues to rise.

Source: Hoisington Investment Management Company, May 2014

As you can see in the table above (which Dr. Lacy Hunt was kind enough to share with us at this year’s Strategic Investment Conference), China has seen its total debt-to-income ratio jump by more than100% (another full turn of GDP) in the lastfive years… more debt growth than any other major economy on the planet, including Japan.

Pulling Back the Bamboo Curtain

Fortunately, my last letter on China’s debt build-up sparked a flurry of introductions and fresh conversations with investors, economists, and policymakers from around the world – in places like London, Spain, South Africa, Singapore, Dubai, Australia, Hong Kong, and Finland. Of course, John has also eagerly introduced me to many of his close friends (who happen to be serious A-list economists and money managers)… so needless to say, it has been an incredibly fun and enlightening couple of months.But John introduced me to one man, in particular, who was able to pull back the curtain on the Chinese economy in a way I had notimagined… and it feels like I am looking at the Middle Kingdom with fresh eyes.Meet Leland Miller, President of China Beige Book International. Along with Dr. Craig Charney, who oversees the firm’s vast research efforts, Leland spearheads the effort to supply the world’s elite institutions (from central banks and heads of state to multinationals, mega-banks, and hedge funds) with a comprehensive look into China’s economy, by applying the same survey methodology employed by each of the regional US Federal Reserve Banks in preparing their submissions for the national Beige Book. Aside from the fact that Leland is an Oxford-educated China historian, a brilliant economist, and a genuinely nice guy, what first caught my attention was his remarkable track record of contrarian calls since the inaugural issue of the China Beige Book in Q1 2012… from the initial slowdown; to unexpected bounces in economic activity; and even the June 2013 cash crunch where interbank interest rates spiked dramatically in a matter of weeks, signaling that a wave of defaults was on the way.(I should note that John has sat on China Beige Book International’s advisoryboard and has worked closely with Leland for most of the firm’s history.)Before we proceed, here is a short but important description of the history and methodology behind the China Beige Book. Although survey data has its limits in any economy, this is as good as it gets for a semi-closed economy like China’s. Beginning in early 2010, our team set out to craft a Chinese analogue of the US Federal Reserve’s Beige Book. Over the next twelve months, we conducted a study of the Beige Book and the methods used to prepare it, including contact with officials at each of the regional Federal Reserve Banks involved in its preparation. We then worked to develop a method that would be similar, but more comprehensive and systematic, in its approach to the world’s second largest economy – a Beige Book “with Chinese characteristics.”Our approach triangulates three methods, repeated every quarter: a quantitative survey of over 2,000 leadingfirms from key sectors across the country; qualitative one-on-one in-depth discussions with C-Suite executives in the same industries across every region; and a separate, targeted banker survey of loan officers and branch managers, designed to home in on the complexities of both the official and shadow economies. With the data from this approach, we are able to compare regions and industries within a quarter, as well as track changes over time, both in near and real time.The result of these efforts is the largest and most comprehensive survey series ever conducted on a closed or semi-closed economy…I cannot share the report in its entirety or reveal too much of its contents, but Leland did give me permission to share part of the regional overviews and research highlights from the Q1 2014 report. If you are able and willing to pay the six-figure annual subscription fee, Leland’s work will blow your mind and dramatically change your perspective. For the rest of us, the following excerpt can at least point us in the right direction… and I am discovering that Leland’s media interviews and tweets (@ChinaBeigeBook) are quite telling, as well.

The pace of Chinese economic expansion has painfully slowed. Revenue, sales, profit, and wage growth are all weaker than a year ago. The slowdown is particularly steep in the North [region 6] and Northeast [region 4] and also pronounced in Beijing [region 3] and Central China (region 5).By sector, stable first-quarter growth in manufacturing confirms our long-standing thesis that it is no longer the economy’s bellwether...

A bounce-back later this year is possible

The worst performer according to CBB figures, both on-quarter and on-year, is real estate and construction. While property companies are getting crushed, the sector is also notoriously unstable for both structural and political reasons. It would be no surprise if real estate were to rally before the end of the year.More immediate reason for optimism: Growth in new domestic orders was solid (save in the Northeast), and domestic orders and export orders were both stronger in powerhouse Guangdong. The results do not indicate a boom later in 2014, but they do suggest that linear forecasts of continued deterioration are overly simplistic.

Financial segmentation is profound

The ongoing debates about monetary policy assume that anticipated loosening or tightening applies across the spectrum of borrowers. CBB data say otherwise, and in multiple ways. First, while the number of firms reporting that they borrowed stabilized in Q1, it did so at a very low level. Shoving more liquidity at the credit market will have limited effects until participation expands. This includes RRR cuts – though of course these may occur for political reasons.Second, shadow finance may be revving up for a comeback.CBB numbers show a recovery in the sales of wealth management products (WMPs), likely due to competition from online banking. This is cash leaving the traditional banking sector and, while non-bank lending did not pick up in the first quarter, the groundwork is being laid for it to do so.

Online banking may be encouraging riskier behavior

Online lenders are typically viewed as a force for liberalization, as well as a potentially healthier alternative to unregulated shadow finance.Yet our data show their proliferation would impart significant costs as well.What appears to be happening is the higher returns available in online banking are forcing banks to move more transactions off-balance sheet, in order to avoid the interest rate cap.While this may accommodate policy goals in the short term, an uptick in off-balance sheet funding portends more shadow bank lending down the line.

Interest rate spread between banks & shadow banks highest in a year

Bank loan rates and bond yieldseased slightly this quarter, but the cost of capital increased again for those borrowing from non-bank lenders.While the shifts were not dramatic, the spread between bank and non-bank loanrates nationwide is now the largest sinceQ1 2013. This highlights the still more challenging road for those firms, principally domestic private entities that are pushed outside formal lending channels.

Growth Is Slowing But Not Collapsing (So Far…)

After reading through the latest report, consulting with friends who are also familiar with the research, and bombarding Leland with a never-ending stream of questions for the last month, John and I still cannot claim to have enough information to make a directional call on the world’s most powerful (and least understood) macro force… but we know more about the inner workings of China’s economy than we did when we wrote to you a couple of months ago.Great data often has that effect – it’s like shining a light into the shadows (including China’s shadow banks). We can see the nuanced regional contrast in economic activity, the modest (but still insufficient) rebalancing between sectors, and pressure points in the credit markets that suggest last summer’s interbank volatility may return in 2014.We also see a far more mixed picture of economic activity than a lot of the widely followed headline data suggests.The overall pace of Chinese economic growth is clearly slowing but not collapsing. The credit transmission mechanism is obviously broken, as you can see in the chart below (with government and government-sponsored borrowers in zombie industries consuming the majority of the country’s credit… in turnforcing households to borrow through shadow banks at massive risk premiums); but so far, the credit bubble is not imploding.On that note, China Beige Book International is the only independent research firm in the world that tracks the non-bank (shadow) lending rates not just nationally, or by region, but for every sector in every region over time.Leland and his team have essentially solved the most difficult China puzzle of all: what is true cost of capital in the Chinese economy, and who is able to actually access it?

Of course – and Leland was emphatic on this point – China’s greatest challenge will lie in deleveraging the economy while also rebalancing toward a consumption-driven growth model for the first time in modern history.That cannot happen as long as households remain repressed by unequal access to credit markets or intentionally suppressed exchange rates, which essentially represent a transfer of household wealth from workers to state-favored firms. But reforming the system will require a greater slowdown than China’s policymakers are letting on. And, Leland warns, Beijing runs the risk of blowing its credibility and instigating capital flight if the divergence between official forecasts and China’s actual economic experience grows too large.To be continued next week....It is time to hit the send button, as trains will not wait. I will report from Tuscany next week, by which time Worth and I should haveChina all figured out – not! But we’ll keep after it. Also, I hope to summarize the speech I did in San Diego. Until then have a great week!Your thinking I need to get to China analyst,John Mauldin

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.